Interest
Rates: Where Are They Heading?
If you
ask most people what they know about interest rates, they might just about be
able to tell you what their current mortgage rate is. If you ask them about the
‘yield curve’ and where rates are likely heading, you will almost certainly get
a blank stare and a swift change of subject!
The point
being that most of us know virtually nothing about what interest rates are, why
they move and where they might be going, and yet we are seemingly quite happy
to take on large debts, either for a mortgage or business loan, with the view
that as rates are currently low it’s a good time to borrow more and ‘she’ll be
right’.
This
attitude has prevailed in many places around the world, and because of the
resulting debt that has been amassed, our debt servicing costs will become
crippling should interest rates start to rise.
We will
discuss what the future for rates holds in a moment, but firstly let’s look a
bit closer at how interest rates are generated.
In most Western societies the process is pretty
similar in that the Central Bank sets the rate at which banks lend to each
other overnight (In NZ this is known as the Official Cash Rate or ‘OCR’).
Under normal circumstances this is the only
rate over which the Central Bank has direct control. There are then a range of
Government bills or bonds of various durations, ranging from one month to
thirty years depending on the particular country.
These
bonds pay a fixed dividend or ‘coupon’, but the price you buy or sell the bond at
can move up or down and is decided by the marketplace, as a result of this
relationship the interest rate of the bond moves inversely to the price of the
bond.
For example:
At Issue
Price of Bond
$100 Coupon $10 Interest Rate 10%
Bond
Price moves up Rate goes down
Price of Bond
$125 Coupon $10
Interest Rate 8%
Bond
price moves down
Rate goes up
Price of Bond
$ 75 Coupon $10 Interest Rate 13.33%
It is
worth noting therefore, that Central Banks the world over cannot control the
yield curve, only the ‘overnight rate’, unless they directly intervene by
buying bonds of longer duration, as many are now doing via Quantitative Easing.
In a
‘normal’ market, the interest rate increases as you move out along the ‘yield
curve’, meaning that 10 year bonds will have a higher interest rate than 5 year
bonds, which will in turn have a higher rate than 2 year bonds, etc.
This can
be illustrated in the chart below of a stylized ‘Normal Yield Curve”
This
intuitively makes sense. As a lender you would justifiably expect to earn more
in interest the longer your money was tied up.
However, there are numerous factors that can
affect the yield curve, including – economic growth and inflation expectations,
perceived investment risks, changes to taxation regimes, political uncertainty,
comparisons to alternative investments, changes in the liquidity within the
financial system, and as already mentioned direct Central Bank intervention, often
making the reality anything but ‘normal’.
Interest
Rates though are like most other things in that they follow a long term trend.
So where in that trend do we currently stand?
Well, New Zealand is
currently enjoying some of its lowest interest rates for decades. The same can
be said for the majority of developed countries, as globally rates have been
trending down for over thirty years, caused by a combination of low inflation,
relatively high returns on investments and a seemingly inexhaustible supply of
easy credit.
The chart
below shows the US
30 year mortgage rate (an excellent proxy for global interest rates), and the
extent and duration of the move is quite apparent.
We can
see that although there have been periods of rising rates, sometimes lasting
for a few years; the long-term trend has clearly been down.
If we now
look at a longer term chart of the US Federal Funds Rate (the ‘overnight rate’)
we can see that prior to the collapse from the highs of 1980, interest rates actually
staged a thirty year rally!
So
putting the information from these charts together, we can confirm that
interest rates do move in predictable long –term cycles, with rallies and
corrections along the way, and that with rates at their current generational
lows and factoring in the number of years that they have been falling, it would
appear that the downtrend in place since 1980 should shortly come to an end.
However,
things may not be quite that simple.
Remember
I said earlier that the period since the 80’s was driven by easy credit, good
investment returns and low inflation? Well whilst that may have been the case
in the early years, it slowly morphed into a low investment return, high
inflation environment where more and more credit was used to paper over the
cracks.
As we now know, the collapse of this house of
cards ultimately lead to the 2008 global financial crisis, and it is the
actions taken by Central Banks around the world to try and stimulate growth
that has pushed rates to these historic lows in the years since.
Unfortunately,
once interest rates are down at these very low levels, the action of cutting
them even further to stimulate the economy tends to have very little impact (the
so called ‘pushing on a string’ effect).
And
irrespective of low rates, the unwinding of the excessive debt burden will lead
to numerous countries defaulting. There is no way to stop it.
So with
these repercussions rolling on for the next few years, Central Banks will
likely keep rates low for some considerable time, and that is precisely what I
expect them to do.
But as we
now know, they do not control the entire yield curve (at least not without
creating other major problems – there is no free lunch!), and as we can see
from what is unfolding in Europe with Greece, Spain, Portugal, Italy etc, even
with low ‘overnight rates’ once the marketplace senses that a country is in
trouble and might not repay it’s debts, its bonds are sold aggressively and interest
rates rise dramatically compounding the problem and making default even more
likely.
This is
what we are currently witnessing. Like a giant queue of naughty schoolboys lined
up to take their punishment, ranked in order of how bad they’ve been, with the
Greek kid at the front. And once he’s had his six of the best, it’s the Spanish
kids turn and so on.
So we in
New Zealand may currently be basking in the warm glow of low interest rates,
but as the sovereign debt crisis unfolds and builds, moving from Europe through
Japan and finally the US, at some stage we will be number one in the queue, and
as we have seen from the charts above, when the trend finally changes interest
rates have a hell of a long way to climb.
So is now
a good time to take on debt because of historic low interest rates?
Well, if
you can weather a substantial rise in rates and still be ok, or if you intend
on paying down the debt over the next 2 to 3 years then the answer may be yes.
But if you are relying on rates staying where they currently are over the long
term, the future will likely be very painful indeed.
Just ask
the Greeks.
